Longevity hedge effectiveness: a decomposition
We use a case study of a pension plan wishing to hedge the longevity risk in its pension liabilities at a future date. The plan has the choice of using either a customised hedge or an index hedge, with the degree of hedge effectiveness being closely related to the correlation between the value of the hedge and the value of the pension liability. The key contribution of this paper is to show how correlation and, therefore, hedge effectiveness can be broken down into contributions from a number of distinct types of risk factors. Our decomposition of the correlation indicates that population basis risk has a significant influence on the correlation. But recalibration risk as well as the length of the recalibration window are also important, as is cohort effect uncertainty. Having accounted for recalibration risk, additional parameter uncertainty has only a marginal impact on hedge effectiveness. Finally, the inclusion of Poisson risk only starts to become significant when the smaller population falls below about 10,000 members over age 50. Our case study shows that, at least for medium and large pension plans, longevity risk can be substantially hedged using index hedges as an alternative to customised longevity hedges. As a consequence, when the hedger's population involves more than about 10,000 members over age 50, index longevity hedges (in conjunction with the other components of an ALM strategy) can provide an effective and lower cost alternative to both a full buy-out of pension liabilities or even to a strategy using customised longevity hedges.
Volume (Year): 14 (2014)
Issue (Month): 2 (February)
|Contact details of provider:|| Web page: http://www.tandfonline.com/RQUF20|
|Order Information:||Web: http://www.tandfonline.com/pricing/journal/RQUF20|
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Dowd, Kevin & Cairns, Andrew J.G. & Blake, David & Coughlan, Guy D. & Epstein, David & Khalaf-Allah, Marwa, 2010. "Evaluating the goodness of fit of stochastic mortality models," Insurance: Mathematics and Economics, Elsevier, vol. 47(3), pages 255-265, December.
- Carter, Lawrence R. & Lee, Ronald D., 1992. "Modeling and forecasting US sex differentials in mortality," International Journal of Forecasting, Elsevier, vol. 8(3), pages 393-411, November.
- Czado, Claudia & Delwarde, Antoine & Denuit, Michel, 2005. "Bayesian Poisson log-bilinear mortality projections," Insurance: Mathematics and Economics, Elsevier, vol. 36(3), pages 260-284, June.
- Coughlan, Guy & Khalaf-Allah, Marwa & Ye, Yijing & Kumar, Sumit & Cairns, Andrew & Blake, David & Dowd, Kevin, 2011. "Longevity hedging 101: A framework for longevity basis risk analysis and hedge effectiveness," MPRA Paper 35743, University Library of Munich, Germany.
- Dowd, Kevin & Cairns, Andrew & Blake, David & Coughlan, Guy & Khalaf-Allah, Marwa, 2011. "A gravity model of mortality rates for two related populations," MPRA Paper 35738, University Library of Munich, Germany.
- Brouhns, Natacha & Denuit, Michel & Vermunt, Jeroen K., 2002. "A Poisson log-bilinear regression approach to the construction of projected lifetables," Insurance: Mathematics and Economics, Elsevier, vol. 31(3), pages 373-393, December.
- Andrew J. G. Cairns & David Blake & Kevin Dowd, 2006. "A Two-Factor Model for Stochastic Mortality with Parameter Uncertainty: Theory and Calibration," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(4), pages 687-718.
- Blake, David & Boardman, Tom & Cairns, Andrew, 2010. "Sharing longevity risk: Why governments should issue longevity bonds," MPRA Paper 34184, University Library of Munich, Germany.
- Cairns, Andrew J.G. & Blake, David & Dowd, Kevin & Coughlan, Guy D. & Epstein, David & Khalaf-Allah, Marwa, 2011. "Mortality density forecasts: An analysis of six stochastic mortality models," Insurance: Mathematics and Economics, Elsevier, vol. 48(3), pages 355-367, May.
- Nan Li & Ronald Lee, 2005. "Coherent mortality forecasts for a group of populations: An extension of the lee-carter method," Demography, Springer, vol. 42(3), pages 575-594, August.
- Wolfgang Reichmuth & Samad Sarferaz, 2008. "Bayesian Demographic Modeling and Forecasting: An Application to U.S. Mortality," SFB 649 Discussion Papers SFB649DP2008-052, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
- Kogure, Atsuyuki & Kurachi, Yoshiyuki, 2010. "A Bayesian approach to pricing longevity risk based on risk-neutral predictive distributions," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 162-172, February.
- Wills, Samuel & Sherris, Michael, 2010. "Securitization, structuring and pricing of longevity risk," Insurance: Mathematics and Economics, Elsevier, vol. 46(1), pages 173-185, February.
When requesting a correction, please mention this item's handle: RePEc:taf:quantf:v:14:y:2014:i:2:p:217-235. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Michael McNulty)
If references are entirely missing, you can add them using this form.